Note: Since last week, interfluidity's readership has grown by an order of magnitude. Which, quite frankly, has me terrified. I wonder whether it's still responsible to post some of my darker provocations. What follows has a very short shelf life, and may or may not capture what's going on in the suddenly urgent quest to sell off Bear Stearns. It's speculation and conjecture, but I think worth considering before anything rash is arranged.
On Friday, Alea's jck pointed us to an SEC press release about Bear Stearns:
According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.
Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns' excess liquidity rapidly eroded.
The title of jck's post was "Bear Raid".
That's not just a pun on the troubled firm's name. "Bear raid" is a term of art for a well-known, usually illegal, strategy. Suppose you know the positions of a heavily leveraged, capital-constrained player, and you'd like to have its assets on the cheap. Rather than trying to buy those assets, sell them short to drive down their prices. At the same time, start rumors that their current owner is insolvent. Soon the target starts getting margin calls it cannot meet, and is forced to liquidate its portfolio to satisfy creditors. This puts even more pressure on the already depressed prices of its holdings. Buy up the dying target's portfolio, along with the assets you sold short, for a song. Ka-ching!
Cassandra offered some wonderful musings on this kind of strategy in connection with the now quaint Amaranth meltdown.
It's unlikely that Bear's little liquidity problem last week was anybody's secret plot. There is quite enough spontaneous, organic panic in the market to explain how a teensy little rumor might spiral into a life-threatening crisis for a firm with an overstretched and uncertain balance sheet.
But, in light of the circumstances, I was troubled to read this CNBC story (via Calculated Risk):
The discussions indicate that potential bidders for Bear have been narrowed to [J.C. Flowers and JPMorgan Chase], although other last minute contenders could still weigh in... time has become a major issue for the investment bank... S&P lowered its long-term counterparty credit rating on Bear to "BBB" from "A," and it placed long-and short term ratings on credit watch with negative implications... Because of that S&P downgrade, bankers have now come to the conclusion that a deal must be done by Monday morning because no one on the street will trade or lend to Bear Stearns, which is rated a notch above junk bond levels... If there's no deal Bear Stearns will have to file for bankruptcy, executives said.
A quick sale, on its face, is an attractive option. It's a "market solution". Bear stockholders wouldn't be completely wiped out, and Bear's counterparties would be relieved to have a stronger player on the other side of their deals.
But a quick sale is likely to be a fire sale, and it's impossible for a transaction of this complexity to be adequately vetted in 72 hours. With all the world trying to get a deal done, whoever "buys" Bear might end up getting the firm's good assets cheaply without fully assuming Bear's potentially unknowable liabilities. (Recall the uncertainty still surrounding Bank of America's purchase of Countrywide.) In the very worst case, to make the crisis go away, the Fed might be asked to backstop some or all of Bear's obligations while a "buyer" cherrypicks the assets.
Viewed as a one-shot affair, this might seem like the best that can be done in a bad situation. But, alas, there are always those unanticipated consequences to consider. Bear Stearns probably was not the victim of an intentional bear raid. But, set the right precedent and the next bank to fall very well could be.
Bear Stearns has already been nationalized all but in name. Executives hinting that the firm will file for bankruptcy unless an immediate sale is arranged are playing a game of chicken with the Federal Reserve, trying to get paid now for stock that may be much worse than worthless when all the books are tallied. They suppose they have leverage, since the Fed has made clear that an abrupt bankruptcy would be too harmful to permit (probably because of Bear's role as a derivative counterparty, see Michael Shedlock).
Suppose that Monday morning, Ben Bernanke is presented with a deal, under which a buyer gets Bear assets on the cheap, Bear stockholders get paid out, and the Fed (implicitly or explicitly) bears residual risk. If the Fed doesn't approve, executives say, Bear will file for bankruptcy. Dr. Bernanke will then have an unappetizing choice. He can say yes, and hope that there aren't any more rumors out there about any other firms. Or he can say no, and make it very clear that if Bear Stearns files for bankruptcy despite the Fed's continuing provision of liquidity, he will do everything in his power to hold Bear executives personally responsible for the crisis that results.
A man who by all accounts is a very nice guy may be forced to play some very hard ball.
Update: Very short shelf life indeed, Monday came on Sunday this week. So, what was the deal? Buyer (J. P. Morgan) does get Bear on the cheap. Bear stockholders get paid a token amount, but really next to nothing. The Fed does bear residual risk, both explicitly via a $30B "+/-" nonrecourse financing arrangement and implicitly since J.P Morgan is even too bigger to fail now. The most important bit, though, is here:
[T]he Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York [which is simultaneously reduced to 3.25%, or the Federal Funds Rate + 25 basis points].
You might call this the "anti-Bear-raid" provision. If this had been in force last week, Bear Stearns would still be a proud Wall Street titan, and we wouldn't have heard a thing. This should be sufficient to head off a round of competitive consolidation by rumor and guile.
Overall, it looks like J.P. Morgan comes out a big winner, Bear stockholders are the losers, and Bernanke & Co. did better than they might have. If, as I speculated, the bankruptcy rumors were BSC execs playing chicken with the Fed, the Fed won. Whether JPM's windfall was luck or craft, we may never know, but parsimony and good sportsmanship suggest we call it fortune, absent evidence to the contrary. At least this deal is makes some effort to think about incentives. An important player has finally been allowed to fail, and a set of perverse incentives was carefully eliminated. Still, this arrangement is very, very generous to everyone other than Bear. One was sacrificed that all might survive. (Was it karma, coincidence, or something else that the one firm that refused to participate in the LTCM bailout would be the only firm not bailed out during the Great Credit Crunch of 2008?)
It's worth noting that the Fed has now committed yet more of its dwindling balance sheet to stabilization, and on easier terms than ever before. Keep a close watch on H.4.1. There's no doubt that the Fed is taking on a lot of credit risk, and is providing a lifeline to other firms no more or less worthy of being made an example of than Bear.
A few puzzling details: The Fed has provided roughly $30B nonrecourse financing (meaning that the Fed absorbs the credit risk) for "largely mortgage-related" assets, but according the J.P. Morgan's presentation of the deal (hat tip Calculated Risk), mortgage-related assets will account for only $20B. What's the other 10B "+/-" about? No mention is made of Bear's role as derivative counterparty, although "JPM will guarantee the trading obligations of BSC and its subsidiaries
Perhaps some of this was discussed in this evening's conference call. I haven't had a chance yet to listen or read a transcript.
Update II: Yves Smith and Calculated Risk both point to signs that Lehman Brothers may be in trouble as well. Given the Fed's new facility, if you think (as I do think) that the Fed would lend taking a 15% haircut from par on Monopoly money to prevent another major firm from falling, I have a hard time seeing Lehman going under.
- 16-Mar-2008, 10:10 p.m. EST: Added update re Monday coming early.
- 16-Mar-2008, 10:30 p.m. EST: Changed update, embedding my comments on the deal rather than putting them in a separate post. Added Update II re Lehman as well.
- 17-Mar-2008, 3:05 a.m. EST: Cleaned up some wording in Update II.